In this article, I’d like to sum up the main requirements of the new IFRS 16 and you’ll find a video in the end.

Why IFRS 16 Leases?

The objective of the standard IFRS 16 Leases is to specify the rules for recognition, measurement, presentation and disclosure of leases.

Special For You!
Have you already checked out the IFRS Kit ? It’s a full IFRS learning package with more than 40 hours of private video tutorials, more than 140 IFRS case studies solved in Excel, more than 180 pages of handouts and many bonuses included. If you take action today and subscribe to the IFRS Kit, you’ll get it at discount! Click here to check it out!

But, why is there a new lease standard when we had an older IAS 17 Leases?

The main reason is that under IAS 17, lessees were still able to hide certain liabilities resulting from leases and simply not present them on the face of the financial statements.

I’m talking about operating leases, especially those with non-cancellable terms.

Under the new standard, lessees will need to show all the leases right in their statement of financial position instead of hiding them in the notes to the financial statements.

What is a lease under IFRS 16?

A contract is or contains a lease if it conveys the right to control the use of an identified asset for a period of time in exchange for consideration (IFRS16, par.9).

This definition of lease is much broader than under the old IAS 17 and you must assess all your contracts for potential lease elements.

You should carefully look at:

Can the asset be identified? E.g. is it physically distinct?

Can the customer decide about the asset’s use?

Can the customer get the economic benefit from the use of that asset?

Can the supplier substitute the asset during the period of use?

If the answer to these questions is YES, then it’s probable that your contract contains a lease.

As I wrote in my article about comparison of IFRS 16 and IAS 17, the impact of this new broader definition can be quite big, because some service contracts (with payments recognized directly in profit or loss) can now be considered as lease contracts (with necessity to recognize right-of-use asset and lease liability).

Under IFRS 16, you need to separate lease and non-lease components in the contract.

For example, if you rent a warehouse and rental payments include the fees for cleaning services, then you should separate these payments between the lease payments and service payments and account for these elements separately.

However, lessee can optionally choose not to separate these elements, but account for the whole contract as a lease (this applies for the whole class of assets).

Accounting for leases by lessees

Warning: Lessees do NOT classify the leases as finance or operating anymore!

Lease liabilityThe lease liability is in fact all payments not paid at the commencement date discounted to present value using the interest rate implicit in the lease (or incremental borrowing rate if the previous one cannot be set).These payments may include fixed payments, variable payments, payments under residual value guarantees, purchase price if purchase option will be exercised, etc.

Let me outline the journal entries for you:

Lessee takes an asset under the lease:

Debit Right-of-use asset

Credit Lease liability (in the amount of the lease liability)

Lessee pays the legal fees for negotiating the contract:

Debit Right-of-use asset

Credit Suppliers (Bank account, Cash, whatever is applicable)

The estimated cost of removal, discounted to present value (lessee will need to remove an asset and restore the site after the end of the lease term):

Special For You!
Have you already checked out the IFRS Kit ? It’s a full IFRS learning package with more than 40 hours of private video tutorials, more than 140 IFRS case studies solved in Excel, more than 180 pages of handouts and many bonuses included. If you take action today and subscribe to the IFRS Kit, you’ll get it at discount! Click here to check it out!

Subsequent measurement

After commencement date, lessee needs to take care about both elements recognized initially:

Right-of-use asset
Normally, a lessee needs to measure the right-of-use asset using a cost model under IAS 16 Property, Plant and Equipment.It basically means to depreciate the asset over the lease term:

Lease liability
A lessee needs to recognize an interest on the lease liability:

Debit Profit or loss – Interest expense

Credit Lease liability

Also, the lease payments are recognized as a reduction of the lease liability:

Debit Lease liability

Credit Bank account (cash)

If there is a change in the lease term, lease payments, discount rate or anything else, then the lease liability must be re-measured to reflect all the changes.

Is this too complicated? Exemptions exist!

If you got this far in reading this article, maybe you find it overcomplicated, especially for “small” operating leases.

Here’s the good news:

You do NOT need to account for all leases like described above.

IFRS 16 permits two exemptions (IFRS 16, par. 5 and following):

Leases with the lease term of 12 months or less with no purchase option (applied to the whole class of assets)

Leases where underlying asset has a low value when new (applied on one-by-one basis)

So, if you enter into the contract for the lease of PC, or you rent a car for 4 months, then you don’t need to bother with accounting for the right-of-use asset and the lease liability.

You can simply account for all payments made directly in profit or loss on a straight-line (or other systematic) basis.

Accounting for leases by lessors

Nothing much changed in accounting for leases by lessors, so I guess you already are familiar with what follows.

Classification of leases

Unlike lessees, lessors need to classify the lease first, before they start accounting.

There are 2 types of leases defined in IFRS 16:

A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an underlying asset.

An operating lease is a lease other than a finance lease.

IFRS 16 (IFRS 16, par. 63) outlines examples of situations that would normally lead to a lease being classified as a finance lease (and they are almost carbon copy from older IAS 17):

The lease transfers ownership of the asset to the lessee by the end of the lease term.

The lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date of the option exercisability. It is reasonably certain, at the inception of the lease, that the option will be exercised.

The lease term is for the major part of the economic life of the asset even if the title is not transferred.

At the inception of the lease the present value of the lease payments amounts to at least substantially all of the fair value of the leased asset.

The leased assets are of such a specialized nature that only the lessee can use them without major modifications.

Accounting for finance lease by lessors

Initial Recognition

At the commencement of the lease term, lessor should recognize lease receivable in his statement of financial position. The amount of the receivable should be equal to the net investment in the lease.

Net investment in the lease equals to the payments not paid at the commencement date discounted to present value (exactly the same as described in lessee’s accounting) plus the initial direct costs.

The journal entry is as follows:

Debit Lease receivable

Credit PPE (underlying asset)

Special For You!
Have you already checked out the IFRS Kit ? It’s a full IFRS learning package with more than 40 hours of private video tutorials, more than 140 IFRS case studies solved in Excel, more than 180 pages of handouts and many bonuses included. If you take action today and subscribe to the IFRS Kit, you’ll get it at discount! Click here to check it out!

Subsequent Measurement

The lessor should recognize:

A finance income on the lease receivable:

Debit Lease receivable

Credit Profit or loss – Finance income

A reduction of the lease receivable by the cash received:

Debit Bank account (Cash)

Credit Lease receivable

Finance income shall be recognized based on a pattern reflecting constant periodic rate of return on the lessor’s net investment in the lease.

IFRS 16 then also specifies accounting for manufacturer or dealer lessors.

Accounting for operating lease by lessors

Lessor keeps recognizing the leased asset in his statement of financial position.

Lease income from operating leases shall be recognized as an income on a straight-line basis over the lease term, unless another systematic basis is more appropriate.

Here you can see that the accounting for operating leases is asymmetrical: both lessees and lessors recognize an asset in their financial statements (it’s a bit controversial and there were huge debates around).

Sale and Leaseback transactions

A sale and leaseback transaction involves the sale of an asset and the leasing the same asset back.

In this situation, a seller becomes a lessee and a buyer becomes a lessor. This is illustrated in the following scheme:

The seller (lessee) accounts for the right-of-use asset at the proportion of the previous carrying amount related to the right-of-use retained. Gain or loss is recognized only to the extend related to the rights transferred. (IFRS 16, par.100)

The buyer (lessor) accounts for a purchase of an asset under applicable standards and for the lease under IFRS 16.

If a transfer is NOT a sale:

The seller (lessee) keeps recognizing transferred asset and accounts for the cash received as for a financial liability under IFRS 9 Financial Instruments.

The buyer recognizes a financial asset under IFRS 9 amounting to the cash paid.

The final word

IFRS 16 prescribes a number of disclosures in the notes to the financial statements.

I’d also like to point out that you have to apply IFRS 16 for the periods starting on or after 1 January 2019 (careful about the comparatives).

You can apply IFRS 16 earlier than that, but only if you apply IFRS 15 Revenue from Contracts with Customers, too (the reason is that these 2 standards are closely related).

Thanks
I have questions related to (IAS 17) old standard.
Our company is doing the convergence to IFRS, as required by regulator from 1-1-2017.We didn’t apply IFRS 15 and therefore for lease we will adopt the old standard. We signed agreement with government (50) years to rent a land @ annual rent of $(803.000). The purpose of the agreement is to build & operate a hotel, which will cost our company about $(87) million
The questions are:
1- Do we need to classify the cost of the hotel as PPE or lease?
2- What about the annual rent of the land is it operating lease or finance lease?
I’m confused as our CFO claiming to capitalized the land rent which paid during the construction period to hotel cost, after the hotels open then the rent of land is to be treat as operating lease.
Your feedback will be highly appreciated

Hi Ahmed,
1. The cost of the hotel will definitely be the PPE (it is not subject of the lease, but you construct it).
2. The rent of the land is an operating lease, because the land has an indifinite useful life. Now, whether the rent during the construction period can be capitalized or not, it’s a huge question and I tried to clarify it here. S.

but i really dont understand why we should use straight line method in recognize revnues or expenses in case of operatin lease i think this will ignore the inflation impact and will show no gross in the company profit if the payments varies from year to another , and in same time iam as alessor cannot ask the lesee to pay more than what was agreed in the contract as payment term .

Hi Silvia
Company A invests in power plant to produce and supply electricity under a PPA (Power Purchase Agreement) to the national grid (govt owned organisation). Assume PPA agreement is for 10 years with possibility of extending for another 10 years. would you consider this as a lease scenario?
Thanks
Hans

Hans, under older IAS 17 yes, that would be a lease because the criterion was that the customer has the right to substantially all of the asset’s output.
Under new IFRS 16 you need to assess whether the customer has the right to direct how the identified asset (power plant) will be used. You must analyse the decision-making rights over the power plant – e.g. dispatch rights (who determines the optimal output of the plant?), curtailment rights, etc. – who has these rights? If it’s a customer (national grid), then well, you have a lease there. It’s not so straightforward and you need to analyze the contract carefully. S.

Hi Silvia, I have Question Please ( If I have rent contract for 5 Years Contains Base rent of 10,000,000 Per Year and 200,000 As service Charges Yearly 5% annual increment As per IAS 17 Total Base rent of the five years Amortized equally on monthly basis. shall we do the same for Service charges ?

Hi Silvia, thank you for your article.
Will you please answer the question about lessor accounting – finance lease.
IFRS 16, 70: “…the lease payments included in the measurement of the net investment in the lease comprise the payments …that are not received at the commencement date”. What if lessee pays some amount before the commencement date (after the inception date)?
I think it should be accounted for as follows:
a) Debit Lease receivable Credit PPE
b) Debit Cash Credit Deferred income
and it will be recognised in income evenly throuthout the lease term.
Am I right?

Hi, Thanks for the valuable information. I need to ask about the journal entries in the book of Lessee . Suppose i have take a building on rent for the period of 10 years. I am lessee and building is identified asset and i have right to use. i am paying 100000 per month. Now what is journal entry for this payment. Whether i have to show the building in my books as right to use asset and Lease liability and depreciate the amount of lease liability over the Lease period. Please clearify the journal entries in the book of Lessee

First of all, thank you for your amazing contribution to the understanding of IFRS. The article is great, but I would like to point out that when the answer is “yes” to the following question, then you probably DO not have a lease contract:

“Can the supplier substitute the asset during the period of use?
If the answer to these questions is YES, then it’s probable that your contract contains a lease.”

Hi.. Assuming that the underlying asset is an investment property (land) in the lessee’s books, what happens to the right of use asset at the end of the lease term in the lessee’s books under an operating lease?
The right of use asset has been measured at FV at the end of each year and the relevant FV adjustments have also been made,
Please recommend the relevant accounting entry as well.

Hello,Silvia! Thanks for this article! Have a question about exemption:
1. Leases with the lease term of 12 months or less with no purchase option – What about lease contracts with the lease term of less than 12 months BUT with the right for prolongation or if contract has wording as following,for example: “the term is min 8 months/ max 13 months” or min till February 11,2019 (and this is the term of 10 months) and max till May 11,2019 “. How these leases should be recognised by lessee?

With respect to applying the short term 12 month exemption:
If we have a building lease terminating on 30.06.2019 however exit terms (for ex an exit fee etc) have all been agreed formally and in writing by 31.12.2018, then would we still be able to apply the short term exemption and continue accounting for the lease as a normal operating lease until termination?

I have a question on subcontractors e.g XYZ has over 3,000 small captive (regular) subcontractors providing their owned vehicles to the company for freight services under the following terms:
• XYZ controls and direct the use of the vehicle to customer location.
• The small contractor has only one to two trucks and works predominantly for XYZ.
• A yearly renewable contract, but majority serviced XYZ for over 3 years and some does not have a signed contract.
• Compulsory attendance at health and safety training held by XYZ sales and delivery procedures training.
• Wear XYZ uniforms and interact with the customers and customer sign acceptance of delivery on XYZ equipment
• On XYZ payment system ( e.g records number of deliveries to calculate monthly subcontractor payment)
• Subcontractor takes the vehicle home daily after working hours
• Any refund for loss of customer parcels are paid by XYZ and amount deducted from subcontractor payments, if the latter is found at fault.

Appreciate your view on whether we should account for 3,000 under Portfolio lease with following:
• Lease term 3 years
• Discount rate is the XYZ’s incremental borrowing rate
• Lease payment is estimated by reference to market vehicle rental rate ( monthly rate)
Or whether we keep those as sub-contractors expense.

Hi Sylvia,
We have some leases for offices for which the initial duration of the contract has ended and since then, the contract is silently renewed every year. In this cases how would you determine the lease period which will be used for the calculation of the RoU and Lease liability?

Hi Sylvia ! thank you for your insightful articles, really finding it easy to follow and understand.
I have a question on IFRS 16 please – what happens on consolidation? what would be the accounting entry to reverse the right of use of the asset, liability and the income statement charge ( interest + depreciation) please? Do you have any examples you could share with us please?

Hi Daniela, are you asking on consolidation when the lease is intragroup? Well, you need to reverse all entries as if they had never happened, since the inception of the lease. Everything booked to profit/loss in previous years is reversed via equity (retained earnings). S.

Hi Silvia! I have two questions.
1. Does this mean that we will create a new account, i.e., Right-of-use account (ROU), in our chart of accounts? Or the ROU was used for discussion purposes only.
2. We are renting an office space in a condominium hotel. Lease term is 5 years subject to annual escalation clause. Is this covered by IFRS 16?

Hi, What happens when lease incentive is higher than the ROU asset and ROU asset is negative?
There could be many scenarios such as either party terminated early or a mutual agreement to provide higher lease incentive.
Using common sense, this should not be allowed otherwise companies can actually make profits when leasing but i came across situation when it is the case. Appreciate your thoughts and thank you in advance.

What if the lease agreement, other than rent, also included the fixed charge of monthly building management fee with effect from the commencement of the lease but subject to adjustment during the lease period.

I need some additional clarification in terms of the below point from IFRS 16, B35
IFRS 16, B35: “If only a lessor has the right to terminate a lease, the non-cancellable period of the lease includes the period covered by the option to terminate the lease.
Question: Practicable description of “the covered period” is not clear. Could you, please, bring an example in terms of Telecommunication, rent for rent of land of stations.

Hi Silvia, thanks for this. I may be misunderstanding but does this mean instead of recognising a rental expense (for a lease on a building) the P&L charge is only shown through depreciation and interest therefore improving our EBITDA position?

Hi Silvia, previously, a Company, which used to obtain vehicles on say vehicle lease finance for a period of 5 years and the asset used to be jointly registered until the lease was padi. In such cases the asset was debited in the books of lessee and the vehicle lease finance was shown as lease liability. Under IFRSs 16, will the vehicle in PPE schedule be replaced by RIght of use asset?? Or is it ok to show as vehicles as was shown by lessee when IAS 17 was in place